Connectedness and Contagion: Protecting the Financial System from Panics

439 Pages·2016·2.649 MB·English

by  Hal S. Scott

Connectedness and Contagion

Connectedness and Contagion
Protecting the Financial System from Panics
Hal S. Scott
The MIT Press
Cambridge, Massachusetts
London, England
© 2016 Hal S. Scott
All rights reserved. No part of this book may be reproduced in any form by any electronic
or mechanical means (including photocopying, recording, or information storage and
retrieval) without permission in writing from the publisher.
This book was set in Palatino LT Std by Toppan Best-set Premedia Limited. Printed and
bound in the United States of America.
Library of Congress Cataloging-in-Publication Data
Names: Scott, Hal S., author.
Title: Connectedness and contagion : protecting the financial system from panics / Hal
S. Scott.
Description: Cambridge, MA : The MIT Press, 2016. | Includes bibliographical references
and index.
Identifiers: LCCN 2015039900 | ISBN 9780262034371 (hardcover : alk. paper)
Subjects: LCSH: Financial crises—History—21st century. | Global Financial Crisis, 2008–
2009—Government policy. | Global Financial Crisis, 2008–2009.
Classification: LCC HB3722 .S385 2016 | DDC 339.5/3—dc23 LC record available at
http://lccn.loc.gov/2015039900
10 9 8 7 6 5 4 3 2 1
To all of those who so successfully fought the panic created by the
financial crisis of 2008

Contents
Acknowledgments xiii
Introduction xv
I Connectedness, Contagion, and Correlation: Definitions and a
Review of the Economic Literature
1 The Concept of Connectedness 3
1.1 Asset Connectedness 3
1.2 Liability Connectedness 4
2 The Concept and History of Contagion 5
2.1 History of Contagion 6
2.2 Panicked Runs: Multiple Equilibria (Outcomes) 9
2.3 Information Economics 12
2.4 Measures of Systemic Risk 14
3 The Concept of Correlation 15
II Connectedness in the Crisis
4 Asset Connectedness: Lehman and AIG 19
4.1 Lehman Brothers’ Collapse and Bankruptcy 19
4.2 Effects of the Lehman Collapse on Different
Counterparties 24
4.2.1 Third-Party Creditors: Exposures and Expectations 25
4.2.2 Derivatives Counterparties: Exchange-Traded, CDS,
and OTC Portfolios 30
4.2.3 Prime Brokerage Clients 47
4.2.4 Structured Securities Investors 48
4.2.5 Money Market Funds 50
viii Contents
5 Liability Connectedness: Money Market Funds and Tri-Party
Repo Market 53
5.1 Money Market Funds and Liability Connectedness 54
5.2 Tri-Party Repo Market and Liability Connectedness 55
6 Dodd–Frank Act Policies to Address Connectedness 59
6.1 Central Clearing 59
6.2 Exposure Limitations 61
6.3 SIFI Designation 62
III Contagion
7 Contagion in the 2008 Crisis: The Run on the Nonbank Sector,
“Shadow Banks” 67
7.1 Overview 67
7.2 Contagion after Lehman 71
7.2.1 Money Market Funds and Commercial Paper
Markets 71
7.2.2 Interbank Lending and Repos 73
7.2.3 Investment Banks 74
7.3 Government Responses to the 2008 Contagion 75
8 History of Lender of Last Resort in the United States 79
8.1 First and Second National Banks 80
8.1.1 General Background and Powers 80
8.1.2 First Bank of the United States (1791–1811) 82
8.1.3 Second Bank of the United States (1816–1836) 84
8.2 Creation of the Federal Reserve System in 1913 and Its
Authority as Lender of Last Resort to Nonbanks 88
9 Dodd–Frank Restrictions on the Lender-of-Last-Resort
Power 93
9.1 Broad Program Requirement 94
9.2 Requirement of Approval by the Secretary of the
Treasury 96
9.3 Loans Only to “Solvent” Institutions 101
9.4 Banks Cannot Use the Proceeds of Discount Window
Loans to Make Loans to Their Nonbank Affiliates 104
9.5 New Collateral Policies Imposed on the Fed 105
9.6 Disclosure Requirements 106
Contents ix
10 Comparison of LLR Powers of Fed with Bank of England,
European Central Bank, and Bank of Japan 109
10.1 Bank of England 109
10.1.1 Sterling Monetary Framework 110
10.1.2 Participation in the Sterling Monetary Framework
and Acceptable Collateral 111
10.1.3 Discount Window Lending 112
10.1.4 Contingent Term Repo Facility Lending 113
10.1.5 Emergency Liquidity Assistance 114
10.1.6 ELA Assistance to Solvent Banks and Nonbanks 115
10.1.7 Lending at Treasury Direction 115
10.2 European Central Bank 116
10.2.1 Emergency Liquidity Assistance 116
10.2.2 ECB and European Commission Authority to Restrict
NCB LLR 119
10.2.3 Liquidity via ECB Monetary Policy Operations 120
10.2.4 Long-Term Refinancing Operations 121
10.2.5 Purchasing Programs 122
10.3 Bank of Japan 122
10.3.1 Article 33 123
10.3.2 Article 38 124
10.3.3 Article 37 125
10.3.4 Article 44 126
10.4 Comparison of LLR Powers of the Four Central
Banks 126
10.4.1 Independence 126
10.4.2 Ability to Lend to Nonbanks and Supervisory
Authority 130
10.4.3 Regime Structure 130
10.4.4 Collateral 131
10.4.5 Requirement of Solvency 131
10.4.6 Treasury Approval or Direction 133
10.4.7 Need for a “Broad Program” 134
10.4.8 Disclosure Requirements 134
10.4.9 Using Discount Window Proceeds to Lend to
Affiliates 135
11 Strengthening the LLR Powers of the Fed 137
12 Liability Insurance and Guarantees 145
12.1 Amount of Liabilities to Insure 148